Nick Clegg suffered a rebuff early this morning when voters spurned the Liberal Democrats to hand Labour victory in Britain's first parliamentary byelection since the formation of the coalition last May.

In a boost for Ed Miliband, the Labour leader, who has faced whisperings about a lacklustre debut as leader, his party easily held the Oldham East and Saddleworth seat as it increased its 103-vote majority at last year's general election to 3,558.

Debbie Abrahams, the Labour candidate, beat the Liberal Democrat candidate Elwyn Watkins by 14,718 to 11,160. Kashif Ali, the Tory candidate trailed in third place on 4,481 votes.

Labour launched a major operation to fire up its base yesterday which saw David Miliband return to the political fray to knock on doors in Oldham. The former foreign secretary was one of 40 Labour MPs who travelled to the constituency yesterday, including members of the shadow cabinet.

Tim Farron, the Lib Dem president, threw in the towel well before the formal result when he toured the media balcony at the count centre in the Oldham Civic Centre putting the best face he could on defeat. Farron declared that Watkins had come a "decent second". "We haven't presented the student fees issue well," Farron said. "I am sure we are being punished for being in government and making unpopular decisions. That is what we have to do. We inherited a deficit of £160-£170bn. We can live in la-la land like Labour and pretend we can just do nothing about like it and end up like Ireland if you like, or we can take the tough decisions to get us through that. We are bound to get some grief."

The new MP, Debbie Abrahams, arrived at the count at 1.15am to storms of applause and promptly disappeared behind a large bouquet of white chrysanthemums delivered by Manchester Interflora and handed over by Andy Burnham. She was hugged by supporters before walking round the still-continuing count, thanking checkers as they ticked off her growing bundles of votes.

Victory was doubly sweet for Abrahams who failed to retain the neighbouring Colne Valley seat for Labour at the General Election in May. She said after the count that she would go into battle for the constituency at Westminster straight away. The defeated Liberal Democrat Watkins said: "I have no regrets about taking the legal action which led to this by-election. I was vindicated. We fought to win and our vote is up, in difficult times for the coalition."

The Conservative Kashif Ali admitted disappointment at the collapse in his vote, but denied that he had been let down by the party nationally. With his qualifications, as a locally-schooled Oldham boy who went to both Oxford and Cambridge and is now a Manchester barrister, he has been tipped for an easier seat in the North West at the next election. He was congratulated for his campaign by Andy Burnham after the election and in turn praised his new Labour MP.

Nick Clegg said this morning: "It was always going to be a big ask to take this seat from Labour, given the circumstances. We are undertaking some enormously difficult decisions because Labour left Britain's economy in a mess and we are now forced to clean up after them.

"By 2015, I hope that the people of Oldham and Saddleworth will see, like everyone else in the country, that the difficult choices we made were the right ones and that Britain is in better shape than when we entered government."

The byelection was caused by the unseating of Phil Woolas, the former Labour immigration minister, after two high court judges ruled that he told lies about Watkins during last May's general election. Woolas, who defeated Watkins by 103 votes, had claimed his Lib Dem opponent had "wooed" Islamic extremists.

The Lib Dem performance in Oldham East and Saddleworth this morning shows the party has been hit by a series of high profile U-turns since the formation of Britain's first peacetime coalition in 70 years with the Tories. The Lib Dems dropped their pledge to abolish university tuition fees in favour of a system that will see fees treble and they accepted Tory proposals for £6bn of public spending cuts this year after warning that they could damage the recovery.

Clegg will hold discussions with all Lib Dem ministers this morning in a pre-arranged meeting as the party assesses its first encounter with the electorate in a parliamentary election since May. The leadership believes the party was damaged by a collective failure to explain the policy adjustments they have made since entering government.

Simon Hughes, the Lib Dem deputy leader, admitted during an eve of poll visit to the constituency on Wednesday that ministers were guilty of "communication and presentational problems" over tuition fees. The remarks by the Lib Dem deputy leader came after a veteran party activist in the constituency accused the leadership of "miserably" failing to communicate the benefits of the changes to university. Brian Lord, a councillor for 24 years, said that numerous voters had wrongly assumed that students would have to pay upfront fees of £9,000 a year.

The Lib Dems also believe they were not helped yesterday when the Labour-controlled Manchester City Council, which employs many Oldham East and Saddleworth constituents, announced that it was cut 2,000 posts as a result of the government's spending cuts. Michael Fallon, the Tory deputy chairman, said: "The announcement was cynically timed to coincide with today's by-election, in full knowledge that a large number of those impacted by the news at Manchester City Council are voting today."

The Lib Dems embarked on a damage limitation exercise in the early hours of the morning as they pointed out that they would have had to break recent political precedent to have wrested back control of the seat which Woolas won for Labour in 1997.

A candidate from a governing party has not gained a seat in a byelection since the late Angela Rumbold won the Merton, Mitcham and Morden byelection for the Tories in June 1982.

Clegg is expected to tell his ministers that electoral rebuffs in the first stages of coalition government are to be expected.

In the meeting at the Institute for Government, the deputy prime minister will say that the experience of continental coalitions show that the junior partner often suffers disproportionately because it does not have such a strong natural electoral base.

The decisive Labour victory will stabilise Ed Miliband's position after a difficult start to his leadership following his narrow victory over his brother. Labour believes that his visit on the New Year bank holiday on 3 January to highlight the VAT increase the following day gave him a chance to push a message that resonated in the constituency and beyond.

Miliband will claim that his overall strategy – acknowledging that the fiscal deficit must be cut but claiming that the coalition is slashing too quickly – is striking a chord with voters. But Ed Miliband, who visited the seat three times during the campaign, wants to warn against any sense of complacency.

The collapse in the Tory vote is likely to prompt renewed pressure on David Cameron from the right who believe the coalition with the Lib Dems has become too cosy. The prime minister had initially planned to give Clegg a clear run in the seat by running a paper candidate, possibly paving the way for a "coupon" general election in 2015 in which the Tories and Lib Dems would agree not to stand against each other in certain seats.

But the Tories decided to run a slightly more energetic, though still halfhearted, byelection campaign after complaints from across the party.

The deputy prime minister and leader of the Liberal Democrats, Nick Clegg, says his party came a strong second in the Oldham East and Saddleworth byelection, which was won by Labour candidate Debbi Abrahams

Victory for Labour in Britain's first parliamentary byelection since the formation of the coalition last May as Debbie Abrahams beat the Liberal Democrat candidate Elwyn Watkins by 14,718 to 11,160 to be the next MP for Oldham East and Saddleworth